Economic Feasibility Studies

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Introduction
“ Every long term decision the firm makes is a
capital budgeting decision whenever it
changes the company’s cash flows.
“ The difficulty with making these decisions is
that typically, many cash flows are affected,
and they usually extend over a long period of
time.
“ Investment appraisal criteria help us in
analyzing capital budgeting decisions by
aggregating the multitude of cash flows into
one number.

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 Introduction
“ The important points are:
“ Capital budgeting is the most significant
financial activity of the firm.
“ Capital budgeting determines the core
activities of the firm over a long term
future.
“ Capital budgeting decisions must be made
carefully and rationally.

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 Capital Budgeting Within A Firm

The Position of Capital Budgeting

Financial Goal of the Firm:

Wealth Maximization

Investment Decison Financing Decision Dividend Decision

Long Term Assets Short Term Assets Debt/Equity Mix Dividend Payout Ratio

Capital Budgeting

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Examples of ‘Long Term Assets’

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 Aspects of Capital Budgeting
Capital Budgeting involves:
1- Committing significant resources.
2 -Planning for the long term: 5 to 50 years.
3- Decision making by senior management.
4- Forecasting long term cash flows.
5- Estimating long term discount rates.
6- Analyzing risk.

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 Aspects of Capital Budgeting

Capital Budgeting:
Emphasize the firm’s goal of wealth
maximization, which is expressed as
maximizing an investment’s Net
Present Value
Requires calculating a project’s relevant
cash flows
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 Aspects of Capital Budgeting

Capital Budgeting Uses:

Sophisticated forecasting techniques:-
•Time series analysis by the
application of simple and multiple
regression, and moving averages
•Qualitative forecasting by the
application of various techniques, such
as the Delphi method
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 Aspects of Capital
Budgeting
Capital Budgeting requires:
Application of time value of
money formula
Application of NPV analysis to
forecasted cash flows

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Aspects of Capital Budgeting
Risk Analysis
•Application of Sensitivity and Break
Even analyses to analyze risk.
•Application of Simulation and Monte
Carlo Analysis as extra risk analysis.
•Application of long term forecasting
and risk analysis to projects with very
long lives
١٠
Unit 2: Project Cash Flows
Training Goals:
1- Understand why to use the
cash flows concept in long term
investment decisions.
2- Discuss the major
components of relevant cash
flows.

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Project Cash Flows
The definition, identification,
and measurement of cash flows
relevant to project evaluation.

١٢
Why Cash Flows?
“ Cash flows, and not accounting
estimates, are used in project
analysis because:
1. They measure actual economic
wealth.
2. They occur at identifiable time points.
3. They have identifiable directional
flow.
4. They are free of accounting
definitional problems.
١٣
The Meaning of RELEVANT
Cash Flows.
“A relevant cash flow is one which will
change as a direct result of the decision
about a project.
“ A relevant cash flow is one which will
occur in the future. A cash flow incurred
in the past is irrelevant. It is sunk.
“ A relevant cash flow is the difference in
the firm’s cash flows with the project,
and without the project.

١٤
Cash Flows: A Rose By Any
Other Name Is Just as Sweet.
“Relevant cash flows are also
known as:-
“Marginal cash flows.
“Incremental cash flows.
“Changing cash flows.
“Project cash flows.

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Project Cash Flows:
Yes and No.
“ YES:- these are relevant cash flows -
9 Incremental future sales revenue.
9 Incremental future production costs.
9 Incremental initial outlay.

9 Incremental future salvage value.

9 Incremental working capital outlay.
9 Incremental future taxes.
١٦
Project Cash Flows:
Yes and No.
“ NO:- these are not relevant cash flows -
: Changed future depreciation.
: Reallocated overhead costs.
: Adjusted future accounting profit.
: The cost of unused idle capacity.
: Outlays incurred in the past.

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Cash Flows and Depreciation:
Always A Problem.
“ Depreciation is NOT a cash flow.
“ Depreciation is simply the
accounting amortization of an
initial capital cost.
“ Depreciation amounts are only
accounting journal entries.
“ Depreciation is measured in project
analysis only because it reduces
taxes.
١٨
 Other Cash Flow Issues.
“ Tax payable: if the project changes tax
liabilities, those changed taxes are a
flow of the project.
“ Investment allowance: if a taxing
authority offers this ‘extra depreciation’
concession, then its tax savings are
included.
“ Financing flows: interest paid on debt,
and dividends paid on equity, are NOT
cash flows of the project.
١٩
Using Cash Flows
All relevant project cash flows are set
out in a table.
The cash flow table usually reads
across in End Of Years, starting at EOY
0 (now) and ending at the project’s last
year.
The cash flow table usually reads down
in cash flow elements, resulting in a
Net Annual Cash Flow. This flow will
have a positive or negative sign.
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Project Cash Flows: Summary
“ Only future, incremental, cash flows
are Relevant.

“ Relevant Cash Flows are entered

into a yearly cash flow table.
“ Net Annual Cash Flows are
discounted to give the project’s
Net Present Value.
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Unit 3: Essential Formulae in
Project Appraisal

A Coverage of the Formula and

Symbols Used to Evaluate
Investment Projects

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Fundamentals in Financial
Evaluation
“ Money has a time value: a $ or £ or €
today, is worth more than a $ or £ or € next
year.
“A risk free interest rate may represent
the time value of money.
“Inflation can create a difference in
money value over time. It is NOT the
time value of money. It is a decline in
monetary purchasing power.
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 Moving Money Through
Time
“Investment projects are long lived, so
we usually use annual interest rates.
“With compound interest rates, money
moved forward in time is
‘compounded’, whilst money moved
backward is ‘discounted’.

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Financial Calculations

“Time value calculations in capital

budgeting usually assume that
interest is annually compounded.
×

“‘Money’ in investment projects is

known as ‘cash flows’: the symbol is:
“ Ct Cash flow at end of period t.

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 Financial Calculations
„ The present value of a single sum is:
PV = FV (1 + r)-t
the present value of a dollar to be received at
the end of period t, using a discount rate of r.

„ The present value of a series of cash

flows is:
t
PV = ∑1
CF t
(1 + r ) t

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Financial Calculations:
Cash Flow Series
“ A payment series in which cash flows
are Equally sized And Equally
timed is known as an annuity.
There are 3 types:
1. Ordinary annuities; the cash flows
occur at the end of each time period.
2. Annuities due; the cash flows occur at
the start of each time period.
٢٧
Financial Calculations:
Cash Flow Series

4. Perpetuities; the cash flows begin

at the end of the first period, and
go on forever.

α
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Unit 4: Investment Decisions
Under Certainty
Training Goals:To Understand How to
use the following Methods:
1. The Net Present Value
2. The Payback Period Rule
3. The Discounted Payback Period Rule
4. The Average Accounting Return
5. The Internal Rate of Return
6. Problems with the IRR Approach
7. The Profitability Index
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1- Why To Use Net Present
Value?
“ Accepting positive NPV projects
benefits shareholders.
9 NPV uses cash flows
9 NPV uses all the cash flows of the
project
9 NPV discounts the cash flows properly

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 The Net Present Value (NPV)
Rule
“ Net Present Value (NPV) =
Total PV of future CF’s - Initial Investment
“ Estimating NPV:
“ 1. Estimate future cash flows: how much? and when?
“ 2. Estimate discount rate
“ 3. Estimate initial costs
“ Minimum Acceptance Criteria: Accept if NPV > 0
“ Ranking Criteria: Choose the highest NPV

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Good Attributes of the NPV
Rule
“ 1. Uses cash flows
“ 2. Uses ALL cash flows of the project
“ 3. Discounts ALL cash flows properly

“ Reinvestment assumption: the NPV

rule assumes that all cash flows can be
reinvested at the discount rate.

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2. The Payback Period Rule
“ How long does it take the project to
“pay back” its initial investment?
“ Payback Period = number of years to
recover initial costs
“ Minimum Acceptance Criteria:
“ set by management
“ Ranking Criteria:
“ set by management

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The Payback Period Rule
(continued)
“ Disadvantages:
“ Ignores the time value of money
“ Ignores cash flows after the payback period
“ Biased against long-term projects
“ Requires an arbitrary acceptance criteria
“ A project accepted based on the payback
criteria may not have a positive NPV
“ Advantages:
“ Easy to understand
“ Biased toward liquidity

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3 The Discounted Payback
Period Rule
“ How long does it take the project to
“pay back” its initial investment taking
the time value of money into account?
“ By the time you have discounted the
cash flows, you might as well calculate
the NPV.

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4. The Average Accounting Return
Rule
Average Net Income
AAR =
Average Book Value of Investent
“ Another attractive but fatally flawed approach.
“ Ranking Criteria and Minimum Acceptance
Criteria set by management
“ Disadvantages:
“ Ignores the time value of money
“ Uses an arbitrary benchmark cutoff rate
“ Based on book values, not cash flows and market
values
“ Advantages:
“ The accounting information is usually available
“ Easy to calculate ٣٦
 5. The Internal Rate of Return
(IRR) Rule
“ IRR: the discount that sets NPV to zero
“ Minimum Acceptance Criteria:
“ Accept if the IRR exceeds the required return.
“ Ranking Criteria:
“ Select alternative with the highest IRR
“ Reinvestment assumption:
“ All future cash flows are assumed to be reinvested.
“ Disadvantages:
“ Does not distinguish between investing and
borrowing.
“ IRR may not exist or there may be multiple IRR
“ Problems with mutually exclusive investments
“ Advantages:
“ Easy to understand and communicate

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 The Internal Rate of Return:
Example
Consider the following project:
$50 $100 $150

0 1 2 3
-$200

The internal rate of return for this project is

19.44%
$50 $100 $150
NPV = 0 = + +
(1 + IRR) (1 + IRR) (1 + IRR) 3
2

٣٨
 The NPV Payoff Profile for This Example

If we graph NPV versus discount rate, we can see the IRR as the
x-axis intercept.
Discount Rate NPV $120.00
0% $100.00 $100.00
4% $71.04 $80.00
8% $47.32
$60.00
12% $27.79
$40.00
NPV
16% $11.65
$20.00
IRR = 19.44%
20% ($1.74)
24% ($12.88) $0.00
28% ($22.17)
($20.00)
-1% 9% 19% 29% 39%
32% ($29.93)
36% ($36.43) ($40.00)
40% ($41.86) ($60.00)
Discount rate

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Mutually Exclusive vs.
Independent Project
“ Mutually Exclusive Projects: only ONE of
several potential projects can be chosen, e.g.
acquiring an accounting system.
“ RANK all alternatives and select the best one.

“ Independent Projects: accepting or rejecting

one project does not affect the decision of the
other projects.
“ Must exceed a MINIMUM acceptance criteria.

٤٠
 7. The Profitability Index (PI) Rule
Total PV of Future Cash Flows
PI =
Initial Investent
“ Minimum Acceptance Criteria: Accept if PI > 1
“ Ranking Criteria:
“ Select alternative with highest PI
“ Disadvantages:
“ Problems with mutually exclusive investments
“ Advantages:
“ May be useful when available investment funds are
limited
“ Easy to understand and communicate
“ Correct decision when evaluating independent
projects
٤١
8 The Practice of Capital
Budgeting
“ Varies by industry:
“ Somefirms use payback, others use
accounting rate of return.
“ The most frequently used technique for
large corporations is IRR or NPV.

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Example of Investment Rules
Compute the IRR, NPV, PI, and payback
period for the following two projects.
Assume the required return is 10%.
YearProject A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
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Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053

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Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CFCum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?

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Relationship Between NPV
and IRR
Discount rate NPV for ANPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
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NPV Profiles
$400
NPV

$300
IRR 1(A) IRR (B) IRR 2(A)
$200

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B

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 Selection of Techniques:
“ NPV is the technique of choice; it satisfies
the requirements of: the firm’s goal, the
time value of money, and the absolute
measure of investment.
“ IRR is useful in a single asset case, where
the cash flow pattern is an outflow
followed by all positive inflows. In other
situations the IRR may not rank mutually
exclusive assets properly, or may have
zero or many solutions.
٤٨
Selection of Techniques:
“ARR allows many valuations of the
asset base, does not account for the
time value of money, and does not
relate to the firm’s goal. It is not a
recommended method.
“PB does not allow for the time value
of money, and does not relate to the
firm’s goal. It is not a recommended
method.

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The Notion of Certainty
“ Certainty allows demonstration and
evaluation of the capital budgeting
techniques, whilst avoiding the complexities
involved with risk.
“ Certainty requires forecasting, but forecasts
which are certain.
“ Certainty is useful for calculation practice.
“ Risk is added as an adaption of an
evaluation model developed under
certainty.

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Unit 5: Risk Analysis

Incorporating Risk Into

Project Analysis Through
Adjustments To The
Discount Rate, and By The
Certainty Equivalent Factor.
٥١
 Introduction: What is Risk?
“ Risk is the variation of future
expectations around an expected
value.
Š Risk is measured as the range of
variation around an expected value.

Š Risk and uncertainty are

interchangeable words.

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 Where Does Risk Occur?
“ Inproject analysis, risk is the variation
in predicted future cash flows.

Forecast Estimates of
Varying Cash Flows
End of End of End of End of
Year 0 Year 1 Year 2 Year 3
-$760 ? -$876 ? -$546 ?
-$235 ? -$231 ? -$231 ?
-$1,257 $127 ? $186 ? $190 ?
$489 ? $875 ? $327 ?
$945 ? $984 ? $454 ?
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 Handling Risk
There are several approaches to hand risk:

Š In this unit, risk is accounted for by (1) applying a

discount rate commensurate with the riskiness of the
cash flows, and (2), by using a certainty equivalent
factor

Š Risk may be also accounted for by evaluating the

project under simulated cash flow and discount rate
scenarios.

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 Using a Risky Discount Rate
“ The structure of the cash flow
discounting mechanism for risk is:-
Riskycashflow1 Riskycashflow2
NPV = 1
+ 2
+ ...... − InitialOutlay
(1 + riskyrate) (1 + riskyrate)

Š The $ amount used for a ‘risky cash

flow’ is the expected dollar value for that
time period.
Š A ‘risky rate’ is a discount rate calculated to
include a risk premium. This rate is known as
the RADR, the Risk Adjusted Discount Rate.
٥٥
Defining a Risky Discount Rate
“ Conceptually, a risky discount rate, k,
has three components:-
“ A risk-free rate (r), to account for the
time value of money
“ An average risk premium (u), to
account for the firm’s business risk
“ An additional risk factor (a) , with a
positive, zero, or negative value, to
account for the risk differential
between the project’s risk and the
firms’ business risk. ٥٦
Calculating a Risky Discount Rate
A risky discount rate is conceptually defined
as: k=r+u+a
Unfortunately, k, is not easy to estimate.
Two approaches to this problem are:
1- Use the firm’s overall Weighted Average Cost
of Capital, after tax, as k . The WACC is the
overall rate of return required to satisfy all
suppliers of capital.
2- A rate estimating (r + u) is obtained from the
Capital Asset Pricing Model, and then a is
added.
٥٧
 Calculating the WACC
Assume a firm has a capital structure of:
50% common stock, 10% preferred stock,
40% long term debt.

Rates of return required by the holders of each

are : common, 10%; preferred, 8%; pre-tax debt,
7%. The firm’s income tax rate is 30%.

WACC = (0.5 x 0.10) + (0.10 x 0.08) +

(0.40 x (0.07x (1-0.30)))
= 7.76% pa, after tax.

٥٨
 The Capital Asset Pricing
Model
“This model establishes the
covariance between market returns
and returns on a single security.
“The covariance measure can be
used to establish the risky rate of
return, r, for a particular security,
given expected market returns and
the expected risk free rate.
٥٩
Calculating r from the
CAPM
“ The equation to calculate r, for a
security with a calculated Beta is:

E (r ) = R f + β (Rm − R f )
~
Š Where :E (r) is the required rate of
return being calculated, RF is the risk
free rate: B is the Beta of the security,
and Rm is the expected return on the
market.
٦٠
Beta is the Slope of an
Ordinary Least Squares
Regression Line
Share Returns Regressed On Market
Returns

0.12
0.10
Returns of Share, %

0.08
0.06
0.04
pa

0.02
0.00
-0.10 -0.05 -0.020.00 0.05 0.10 0.15 0.20

-0.04

Returns on Market, % pa ٦١
 The Regression Process
The value of Beta can be estimated as the
regression coefficient of a simple regression
model. The regression coefficient ‘a’ represents
the intercept on the y-axis, and ‘b’ represents
Beta, the slope of the regression line.

r it = a + b i r mt + u it
Where
rit = rate of return on individual firm i’s shares
time t
r mt = rate of return on market portfolio at time t

٦٢
The Certainty Equivalent Method:
Adjusting the cash flows to their ‘certain’
equivalents
The Certainty Equivalent method adjusts
the cash flows for risk, and then discounts
these ‘certain’ cash flows at the risk free
rate.
CF 1 × b CF 2 × b
NPV = + etc − CO
(1 + r )1
(1 + r )2

Where: b is the ‘certainty coefficient’

(established by management, and is between 0
and 1); and r is the risk free rate. ٦٣
 Analysis Under Risk:Summary
“ Risk is the variation in future cash flows
around a central expected value.
“ Risk can be accounted for by adjusting
the NPV calculation discount rate: there
are two methods – either the WACC, or
the CAPM
“ Risk can also be accommodated via the
Certainty Equivalent Method.
“ All methods require management
judgment and experience. ٦٤